Lessons from J. Crew: How to Protect Investors in Management Buyouts

By Deal Journal

Ronald Barusch spent more than 30 years as an M&A practitioner at Skadden, Arps, Slate, Meagher & Flom LLP before retiring this year. He is no longer affiliated with the firm and the views expressed here are his own.

***

By Ronald Barusch

J. Crew Group has announced another in what could be a wave of management-led buyouts. It’s a buyout that should raise eyebrows: not only is management involved, but a buyout firm represented on the board of J. Crew, TPG, is putting up the bulk of the cash.

And TPG is a recidivist—it took the company private in 1997, exited through an IPO and subsequent sales beginning in 2006 and now thinks the timing is good to buy again.

The timing is so good that the deal is priced about 15% below J. Crew’s 52-week high. Buying low and selling high is good work if you can get it—and generally one would expect management is in the best position to take advantage of good timing.

AP

J. Crew says it’s a good deal, that the independent directors were all over the process and that there will be an almost two month “go shop.” The breakup fee also is fairly soft, probably a sign the J. Crew board knew the spotlight would be on their actions.

Still, this post is not really about J. Crew — at least not directly. In theory, there is nothing wrong with management buyouts. If the terms are good, if a competing bidder is allowed the chance to swoop in, and if the shareholders want the price, management-led deals can be good for everyone.

Yet some of us on the outside have a queasy feeling about management buyouts.

For example, compare the reactions of boards like those of J. Crew and Exco Resources in considering proposals from their respective managements to the reactions of Airgas to the Air Products bid or Genzyme to the Sanofi bid. In the latter two hostile deals, it appears the board is willing to fight for every last dollar. However, in management buyouts like the Exco deal, the board seems to be a bit more helpful in getting the buyer to the right terms.

Maybe this can be explained by the terms of the particular deal–perhaps the management buyout prices are themselves more generous, or their timing is better. But it is hard not to be suspicious that, for management, things are just a bit easier. And they have the best insight into market timing.

But improvements are possible. What I suggest is that on a clear day — long before there is any hint of a buyout and in connection with their routine governance process — boards of directors set out and publicly disclose certain basic principles of how they would treat a management buyout if it ever came up. This help keeps a board –- and not its management –- firmly in charge.

Here are some principles I would suggest:

Before a Transaction is Allowed to Start:

Corporate Information. Detailed financial and business information about the company is the exclusive property of the company.

It should never be shared with a buyout sponsor or used by management or any director for a possible buyout without prior board approval. The decision process will include formation of an independent committee and retention of legal advisers at this early stage.

The decision of whether to permit such use will be taken seriously and only be agreed to if the independent committee makes a substantive decision that pursuing the next step is in shareholders’ interests. In theory, the committee should not permit such use unless it would be willing to share the information with a third party who expressed a similar interest—undoubtedly a very high standard.

Management. Management is compensated to manage and operate the business on a full time basis. It should not have substantive discussions concerning a buyout unless the independent committee has given its express permission based on the principles outlined above.

Golden Parachutes. Before allowing the sharing of information and management activities, the independent committee and compensation committee will conduct a comprehensive review of all compensatory change-of-control arrangements. Change-of-control compensation is not intended to be used to fund equity purchases by management in a buyout.

Moreover, management should not be compensated by both the seller and a buyer in connection with a transaction. Therefore, these committees must consider whether reduction or elimination of golden parachute payments may be appropriate as a condition to the commencement of any talks.

Competition. If feasible, several–or at least two–buyout sponsors should be given access simultaneously and should compete to offer the best terms for the company’s shareholders. Management will not be permitted to discuss its post-buyout compensation or equity participation in any respect without prior independent committee approval. Nor will it be permitted to favor any possible bidder.

Terms of a Transaction:

Generally, the Board will not approve a transaction in which management is involved unless it conforms to the following:

Exclusivity. Management may not agree to work exclusively with one bidding group. A third party who makes a bid must have equal access to management and have the opportunity to work with them on the same terms.

No Lockups. To the extent management has significant share ownership, management must agree to vote its shares on any transaction in accordance with the recommendation of the board.

Deal Protections. Deal protections will be minimal. Breakup fees, if any, will be required to be significantly less than would be acceptable for a third party deal and generally limited to a capped amount of reasonable out-of-pocket expenses, particularly if there has not been an opportunity to shop the transaction to competitive bidders prior to signing an agreement. Management may, under no circumstances, share in any breakup fee.

PE firms should understand prior to expressing interest in a management buyout that they will be taking significant risks if third parties offer better terms; this is a cost of being allowed into the process at the early stage and they should not begin diligence if this is not acceptable.

No matching rights will be permitted: in the event of a higher offer, the board will have the right to terminate the original deal without notice and sign an agreement with the higher bidder.

Comments (2 of 2)

Management is paid (handsomely) to manage the compayny as well as possible. I can understand a third party thinking they could do a better job than current management. But current management saying 'we could do better"? Isn't this admitting that they are currently mismanaging? There's just too much (way too much) room for conflict of interest!

2:07 pm November 26, 2010

north fork investor wrote :

This is a superb set of proposed principles. Of course under Delaware law a board could announce them and just ignore them as long as certain CYA procedures were followed and breaches of duties of loyalty weren't too eggregious.

Thanks for reading Deal Journal. We would like to direct you to MoneyBeat, the Wall Street Journal’s brand new global blog. MoneyBeat unites MarketBeat, The Source, Overheard and all the Deal Journal blogs, bringing together all the market, M&A, IPO and hedge-fund news from those blogs into a 24-hour hub for finance news. Check it out and let us know what you think at moneyblog@wsj.com.

About Deal Journal

Deal Journal is an up-to-the-minute take on the deals and deal makers that shape the landscape of Wall Street, including mergers and acquisitions, capital-raising, private equity and bankruptcy. In short, wherever money changes hands. Deal Journal is updated throughout each trading day with exclusive commentary, analysis, data, news flashes and profiles. The Wall Street Journal’s David Benoit is the lead writer, with contributions from other Journal reporters and editors. Send news items, comments and questions to deals@wsj.com.